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This article explains the inheritance tax planning benefits of making regular gifts out of income. This article assumes that you are familiar with the basic workings of inheritance tax.

If you have substantial income, whether from earnings, savings, investments or pensions, you can make significant reductions to your potential UK inheritance tax (IHT) liability by making gifts from what is known as ‘normal expenditure out of income’.

Normal expenditure out of income

You may be familiar with, or already advising your clients about the annual IHT exemption, however, if your clients wish to pass on greater sums of money, this exemption may not be enough. If your clients would like to increase the value of IHT-free gifts they can make year-on-year, they may also want to consider using the ‘normal expenditure out of income relief’ to make gifts.

All transfers, or gifts, are exempt from IHT if:

They are made as part of their normal expenditure.

They are made out of their ‘natural’ income.

After allowing for all transfers taken from normal expenditure, they are left with sufficient income to maintain their usual standard of living.

The payments are habitual or regular.

What is ‘natural’ income for the purposes of normal expenditure?

Natural income comes from traditional, taxable income and can include:

Dividends from investments

Interest from bank accounts

Earned income

Income from UK pensions, including payments from capped or flexi-access drawdown.

It cannot come from:

Capital from existing savings and investments, or

Regular withdrawals taken from ‘non-income producing’ investments such as life assurance or capital redemption contracts.

Annual exemption

Each individual can gift £3,000 every year without any IHT liability. It is also possible to carry forward any unused allowance from the previous year, although the current year’s allowance must be used in full before the previous year’s allowance becomes available. This can be useful when making gifts or paying into regular premium contracts held in trust.

What are considered as ‘habitual and regular’ payments?

UK HM Revenue & Customs (HMRC) will usually consider a payment (in this case, a gift) to be regular or habitual if it has been made across three or four years, with the intention of continuing to make further, similar payments. However, even if you should die after only one such gift, it’s possible to establish that it meets this requirement, if it can be shown that it was your client's intention to make the gift regularly on a habitual basis.

Documentary evidence of your client's intentions (see Recording the evidence section) is therefore important. The facts of each case will be considered by HMRC on its individual merits.

Gifts do not have to be of a fixed amount and can vary from year to year, but generally should evidence an established pattern over a number of years to be considered habitual or regular.

If all these conditions are met then there is no limit on the amount which can be gifted and immediately exempt from IHT.

You should ensure that your clients do not need access to the payments, as by implication this would mean that your clients are not left with sufficient income to maintain their usual standard of living.

It is generally accepted that placing these payments into an investment product, such as an offshore bond, can provide the potential for increased returns and may assist with recording the payment details (see Recording the evidence section below).

A further option is to place the investment product within a trust arrangement.

Recording the evidence

Recording the evidence

It would be prudent for your clients to keep a full record of any payments for which they intend to claim the ‘normal expenditure out of income’ exemption. This will allow their family, upon their death, to complete HMRC’s form IHT403 (Page 6). This form asks for a breakdown of expenses in order to justify the claim that their standard of living had not been affected by the gifts made.

Your clients might find that a letter, using the example wording shown below, proves helpful in providing a sufficient audit trail. However, whilst we believe this wording to be suitable, we are unfortunately unable to guarantee that this wording will be acceptable to HMRC. We would also recommend that your clients complete and retain an IHT403 (Page 6) form each year so that this information doesn’t have to be collected retrospectively.

Recording the evidence – example wording

Gift of £11,500 on 11 May 2015

I confirm that this annual gift:

is made as part of my normal expenditure;

has been made out of income; and

has not affected my usual standard of living.

I have attached a summary of my income and expenditure for the tax year 2015/2016.

Summary

If your clients wish to use their normal income for IHT planning, and for it to have an immediate effect on their IHT liability, this method may be appropriate. If they have a large capital sum available, or other easily accessible investments, then alternative methods of IHT planning may be available, which could prove more beneficial. Whilst there is flexibility on the size of the payments they can make, this arrangement does need to be considered as a regular commitment.

Please bear in mind that this arrangement will not be confirmed as IHT efficient until HMRC verifies that the gifts made qualify for this IHT exemption. This will not happen until the full paperwork is presented to them following your client's death. Based upon current legislation, we believe the process outlined in this article should allow for a successful conclusion.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown on the title page. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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